No logic for FIIs to invest in debt as arbitrage dips'

The economic logic for foreign funds to invest in domestic debt instruments is withering away as yield differentials are narrowing fast, owing to a steep fall in the rupee, a senior SBI official said on Tuesday. The official also said that looking at the real interest rate and the macro fundamentals of the economy, the rupee has to depreciate by 5% every year.

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"The rupee fall is primarily due to (US Fed chairman) Ben Bernanke's statement of a possible QE3 slowdown. Also, the US interest rates have gone up of late. If you see the yield of 10-year US treasury is more than 2.21%," said SBI deputy managing director and group executive for global markets P Pradeep Kumar.

He further said while the 10-year benchmark yield in the domestic debt market is hovering around 7.3-7.4%, arbitrage opportunity for the FIIs is fast squeezing in the domestic market because of higher hedging cost due to fall in rupee.

"So, the economic logic in investing here is not there as the hedging cost will be around 6% for FIIs, prompting them to pull out their investment," Kumar said during an interaction.

Currently, the US treasury note for 10 years hovers around 2.1%, while it is around 7.3% for Indian 10-year benchmark yield. However, when FIIs take an exposure in Indian bonds, they have to hedge it against exchange rate risk, which comes to around 6%.

So, the effective return for FIIs comes to 1.3% (7.3% minus 6%) as of now in Indianbonds, in comparison to 2.1% offered in US 10-year treasury note. Kumar also said the rupee has to depreciate by at least 5% every year on the basis of macro fundamentals.

"In the long run, the rupee has to depreciate because there is both interest rate and inflation differentials between the US and India," he said.

Referring to the short-term movement of the rupee, Kumar said it will depend on the flows. The domestic currency has lost over 7% since the first week of May on the back of pulling out of foreign flows, which was around USD 3.9 billion from the debt market, due to apprehension of tapering of the US stimulus.